Monetary Policy: The Negative Real Shock Dilemma

As we’ve seen, it can be difficult for the Federal Reserve to course-correct when dealing with a sluggish economy suffering from an aggregate demand shock. Now we’re going to see what happens when a negative real shock hits.

For instance, suppose we see a reduction in the oil supply, which causes a rapid increase in the price of oil. It’s unexpected and it’s difficult for the economy to quickly adjust. A negative real shock like this will shift the long-run aggregate supply curve inward, to the left. Growth decreases and inflation increases.

How can the Fed combat this situation? Here’s where it gets really tricky: decreasing the money supply will help with inflation, but it’ll also hinder growth. Increasing the money supply will increase aggregate demand and real growth, but lead to higher inflation. Yikes!

Remember, economic data can be super difficult to get right in real-time. Higher inflation may show up well before the sluggish growth does. The Fed might take action under this incomplete data, potentially moving the economy in the wrong direction.

We’re still not done! Everything in the real world is intertwined. A negative real shock, like an oil crisis, can have an impact on consumer confidence. Can you guess what this means? Yep, a negative real shock can often be accompanied by an aggregate demand shock, making the Fed’s job all the more complicated.

We’ll cover more details on how the Fed responds to negative real shocks, and the double-whammy of a negative real shock and aggregate demand shock, in the video.